Credibility of Inflation Forecasts

Given the raging chronic debate between Ministry of Finance (MOFED) and Bank of Mauritius (BOM) on monetary policy stance in particular REPO rate, it is imperative that we professionalise not only the debate on the direction and impact of REPO in the wake of the Monetary policy Committee decisions, but also ensure that all decisions are based on quality and accurate forecasts. The above table clearly indicates how inflation forecasts by Bank of Mauritius have been failing and on the higher side. For the last three years, we can see the marked difference between actual and forecast. The latest inflation forecast for the year 2014 is 3.9 to 4.3 per cent by BOM and this looks realistic given the low rate of economic expansion expected this year. If we accept the growth forecast of below 4 % by IMF till 2019, then a period of price stability should be expected.
Forecasting is a very delicate exercise and some margin of error is acceptable. However consistent inaccuracy of forecasts on which monetary policy is based with its implications on economic decisions of major stakeholders can jeopardize and misguide policy decisions. In fact, all economic indicators including growth should be well predicted. But given the complexity of our economy and external factors, it would be more trivial to forecast growth rate. However, it seems that during recent years, the forecast of growth rate has improved.

The BOM and MOFED controversy can be clearly explained in terms of agency theory which claims that asymmetric information leads to a moral hazard problem : the agent (BOM) is maximizing its own objective, namely price stability which is not compatible with MOFED's focus on investment and economic growth. In this case, BOM also has a mandate which conflicts with MOFED's objectives. In order to reconcile the objectives, we need to have an analysis of the relationship between REPO rate, savings, investment and economic growth.
It is imperative to involve experts and use a scientific approach for any economic decision-making. In the case of REPO rate and MPC, robust econometric results on the following issues should be used :
1.      Determinants of commercial banks interest rates
2.     Monetary transmission mechanism and what works in Mauritius interest rate, exchange rate and credit channel.
3.     Impact of Repo rate on savings, inflation and investment
4.     Would a fall in REPO rate lower debt burden of creditors?
5.     Are our financial markets integrated?
6.     What is the relationship between growth and inflation? Is the relationship bidirectional or unidirectional? Does low growth lead to low inflation?

According to my published research works, I have found evidence that monetary transmission mechanism is very weak and credit availability determines economic growth. Changes in interest rates have no significant impact on savings and investment. There is a positive and significant relationship between interest rate and inflation rate via the supply side that is on the costs of production.
To conclude, there is a need for the BOM to improve its inflation forecasts in order to improve its effectiveness in interest rate and monetary management. This applies also to MOFED as well as other institutions in Mauritius. The latest IMF report has appreciated the good work of Monetary policy Committee for crafting the right accommodating monetary policy stance.